Thursday, March 29, 2012

Chairman Bernanke gave a lecture on the origins and mission of the Fed where he criticized the gold standard.

George Selgin, who is a bit of a fan of the gold standard (though skeptical of the desirability of returning to it,) takes Bernanke to task.

I broadly agree with Selgin, though I my understanding of the gold standard comes closer that of Glasner, who also criticizes Bernanke. Sumner sees things in much the same way.

One issue has to do with the resource cost of a gold standard. Bernanke takes the old Friedman approach, and assumes a 100% reserve gold standard. Gold must be mined out of the ground to serve monetary purposes is a cost.

In reading through some discussion of this debate at Marginal Revolution, I added to the discussion two thoughts.

First, focusing on the resources used to mine gold is a mistake."Fractional reserve" banking means that we can use lots of gold for jewelry, dental work, and electronic circuitry. Relatively little of the gold that has already been mined out must be stored in vaults as "backing" for paper money or used to make coins.

Second, suppose gold coins were minted about the size of the old $10 coins but denominated as $100,000? (I think those coins are about 1/2 ounce and so the metal value today would be about $800.)

Now, further further suppose that there is no free coinage. The mint issues these in a quantity sufficient to keep nominal GDP on a 3% growth path. (The Mint could target a constant CPI, a 2% inflation rate, or any number of other things.)

New coins are issued to purchase outstanding government bonds. The bonds are then retired, if the Mint balance sheet is consolidated with the rest of the Treasury, or they could be held by the Mint as intergovernmental lending.

Excess coins are withdrawn from circulation by issuing new government bonds, selling them for the coins, and retiring them. (If the Mint held government bonds, then it could sell them on the market.)

Federal Reserve notes (and balances at the Federal Reserve banks) are redeemable in these coins. Perhaps commercial banks could be permitted to issue banknotes and the clearinghouse function of the Fed privatized.

Is it a gold standard?

Is free coinage a necessary condition for a gold standard?

How much seignorage is allowed? Can the seignorage vary?

I think it is pretty clear that the "gold standard" I have described requires very little gold to operate.

I have been thinking about this system in the context of the monetary provisions of the U.S. Constitution. Would this system be consistent with the power of Congress to coin money and determine its value?

Koenig has a short paper that discusses nominal income targeting, comparing and contrasting it to the Taylor rule.

He argues that nominal income targeting is an example of flexible inflation targeting, as is the Taylor rule.

His version of nominal income targeting is a level target. However, it is not the same as the usual proposal of having a series of targeted levels increasing at a constant growth rate--such as 3% or 5%.

Instead, the Koenig version of nominal income targeting sets a target for nominal GDP 5 years in the future by taking the current price level, increasing it based upon a targeted inflation rate, to get a target for the expected price level and multiplies that by the current forecast for potential output five years in the future. The math is in logs, so it is the price level plus 5 times the target inflation rate plus the expected level of potential output in five years that result in a target for nominal GDP in 5 years.

Of course, next year's target will already be determined, approximately 4 years ago. There would be an already determined set of targets for the next four years that the Fed would be seeking to hit now, with the fifth year's target being newly set.

That Koenig should see this as an example of flexible inflation targeting should be no surprise. First, there is an inflation target in the rule. The target for nominal GDP is set according to a given inflation target and a changing estimate of the level of future potential output.

More importantly, the current price level is adjusted by the targeted inflation rate to generate a quasi-target for the price level five years in the future. The expected value of potential real output is then added to the price level to find the target for nominal GDP. (The log version.)

Suppose for one reason or another, the current price level is below its expected value this year. This might be because nominal GDP is below target or else because potential output is higher than was forecast. It is this unusually low price level that is projected five years into the future, generating a "low" quasi-target for the price level in five years. When added to the estimate of potential output in five years, this results in the target for nominal GDP.

With inflation targeting, assuming a 2% rate, the goal is for prices to rise 2% from their current value, wherever that happens to be. Koenig's version of nominal income targeting would seek to make the expected price level, five years from now, approximately 10% higher than the current price level, whatever it happened to be. The nominal income targeting element would occur because if potential output were different from what was expected, then the price level would vary from this expected value.

What is the benefit of adding this element of inflation targeting? I don't see one. Worse, this scheme could generate a large sudden change in nominal GDP five years in the future--between the target for 4 years and 5 years. The year four target is already determined. If the price level is extra low or high this year, then the five year target will decrease or increase in proportion. This would not be due to a sudden shift in potential output between year 4 and 5. The equilibrium price level would suddenly need to shift between year 4 and 5. While we would have 5 years to plan for this, it seems likely to be disruptive.

The other element, constantly forecasting potential output in the future, is very focused on a target for inflation (or the price level.) There is no need to worry about the current price level at all. Take the current target for nominal GDP and add to it the "target" for inflation times 5 and add that to the forecast growth of potential output over the period.

I support a target growth path for nominal GDP with a 3% growth rate rather than 5% or 2% because I favor a stable price level and nominal income growing with real income. I favor nominal income targeting because I think trying to stabilize the price level when there are supply shocks is very disruptive.

Still, why the trend of 3%? Obviously, this is based upon an assumption of a 3% trend growth rate for potential output. It is hard to understand why one nominal GDP growth rate would be better than another without some assumption regarding trend growth of potential output. (Frankly, I find 2% inflation to be a complete puzzle. Why 2 rather than 1, .2, or 3?)

On the other hand, it is not at all clear what benefit is generated by continual readjustment of the growth rate of nominal GDP. Koenig is certainly correct that any such adjustment should have a lead time, and perhaps 5 years is appropriate. But rather than set a level for nominal GDP five years in the future based upon expected growth of potential output over the next five years, I would instead adjust the growth rate five years in the future. For example, if there is really good reason to believe that potential output will be growing 1% per year five years in the future, and will remain at that low rate for many more years, then perhaps committing now to that new growth rate would be desirable. So, for the next five years, the targets for nominal GDP would continue to grow 3%, but then, starting in five years, the targets would rise only 1%.

The way I see it, the 3 percent target would be generating mild inflation because real GDP growth has slowed down. To fix what appears to be a permanent "problem," of a new, slower growth rate, an adjustment is made now, taking effect after people have time to adjust to it.

However, I don't think adjusting the target every single year, even with five year warning, is desirable. Partly this is because I am doubtful that much trouble is caused by having a productivity slowdown result in mild inflation. Or, on the other hand, there being a mild deflation due to an acceleration of productivity growth. When do short run "supply shocks" become new trend growth rates of potential output? When does the superior ability of final goods prices to adjust turn into a problem?

Further, making the adjustments in the way proposed by Koenig appears problematic. Again, the target for nominal GDP is already determined for year four. Suppose that this year it is determined that there will be a productivity slowdown over the next five years. The target for nominal GDP in year 5 is then set so that the expected price level will be such that the inflation rate will be at target. This involves a decrease in the target for nominal GDP in year 5. The change between year 4 and year 5 could be quite sharp. Since the slowdown in potential output isn't going to be happening between year 4 and 5, this implies a large drop in the equilibrium price level. Again, there will be plenty of time to get ready for that nominal shock, but it still seems like it would be disruptive.

It is good news that skilled economists at the Federal Reserve are taking a serious look at nominal GDP targeting. In terms of internal Fed politics, I am sure that showing continuity with flexible inflation targeting is helpful. Still, smuggling in too much inflation targeting can cause problems.

Wednesday, March 28, 2012

The U.S. Constitution gives Congress the power to tax. If Congress wants, it could impose a payroll tax to fund healthcare. It could provide a credit against that tax for the purchase of an approved insurance policy. It could contract with private insurers to provide insurance for everyone subject to the tax who doesn't use the credit.

Instead of using this approach, Obamacare requires those who don't buy a qualified insurance plan to pay a "penalty," but the penalty looks like a tax. Aside from calling the payments by those without a qualified insurance plan a "penalty" rather than a tax, the major difference between the system above is the extra paperwork for those buying qualified insurance plan. Presumably, HR departments would not have to file paperwork to the taxing authority showing the amount they are paying for the plan and the tax owed. Those who actually buy individual policies would not have to file paperwork to get their credit.

Apparently, Congress could skip the extra paperwork and rather than taxing all workers, it could tax people who don't have health insurance that meets certain requirements. The uninsured individual payroll tax. Then, the only difference is the use of the word "penalty" rather than "tax."

As a practical matter, this does matter. There are many legal issues where there is basically no substantive question and just a failure to follow some procedure. If you fail to file some paperwork by some arbitrary deadline, and then you are out of luck.

Further, there has been an election between the time Obamacare passed and when some new, "formally-correct" version might pass. It is almost certain that there will be another election before any change could pass.

So, clearly it matters. If the Supreme Court overlooks the formality, then repeal of the individual mandate would need to be able to pass the House and Senate where it can be filibustered, as well as survive a veto. None of that is possible today, and it is unlikely it will be possible in six months.

On the other hand, if it is overturned, the individual mandate is unlikely to implemented any time soon. The economic crisis, the unpopular wars, the kowtowing to the religious right, resulted in a massive rejection of the Republican party, particularly among independents. This providing an opening for the Democratic party to greatly increase government intervention in the health insurance market.

Should the failure of the Obama administration to use the term "tax" rather than "penalty" enough to overturn this narrow window of opportunity? Should the Supreme Court impose a "penalty" on the faction that had this great bit of luck and require them to go back to trying to build something closer to a consensus? Perhaps.

What I find most irritating is that apparent that many people, including some Justices, are blind to this fundamental reality. Is there some kind of market failure in the insurance market that this legislation is aimed at correcting? Is there some kind of public purpose in paying for healthcare? Is that conditional on government requiring that the healthcare be provided?

These questions are irrelevant. It would be possible to answer yes, and simply point out that the federal government does not have the authority to deal with these issues, and that if these problems are to be dealt with by government, they must be dealt with by state or local government. Of course, that is really not too relevant because the U.S. Constitution does not limit limit on the taxing power in a way that prevents the use of credits and deductions. And so, the question is merely one of procedure, and one of politics. Did the Democrats waste their tiny window of opportunity to push this policy on the American people by failing to follow the proper procedure?

Saturday, March 24, 2012

Market monetarists generally favor a monetary regime that keeps some measure of nominal spending on output growing at a slow steady rate. Keeping nominal GDP growing at a slow stead rate is the most common approach. However, there are occasional mentions of per capita nominal GDP or even nominal GDP per member of the working age population.

The basic idea is that if there are more people, and in particular, a larger labor force, then the productive capacity of the economy will be larger, and so more spending on output would be appropriate. Or, alternatively, with a larger population, and in

particular, a larger labor force, keeping nominal income per worker growing at a slow, steady rate will be more consistent with maintaining full employment of labor.

Per capita nominal GDP is relatively easy to construct. It is also possible to calculate nominal GDP for the civilian eligible population, which is everyone over 16, not in the military, prison, nursing homes, or hospitals. Unfortunately, that includes all retirees. Still, it is possible to get the eligible population between 20 and 64. I had to add up the 20-24, 25-54, and 55-64 groups to find it. So, I found nominal GDP per person 25-54 too.

The trend growth rate for nominal GDP is 5.4% from 1985 to 2008. For all of the rest, the trend growth rates are very similar. For per capita GDP is is 4.26% and for the others it is 4.19%. It is hard to see much difference, though presumably, the reason to go with one of the other figures is to be prepared large shifts in the total population or shifts in the age composition of the population.

Some time ago, someone recommended that I read "Price Expectations, Monetary Disturbances, and Malinvestments," by F.A. Hayek. It was from a lecture he gave in Copenhagen in 1933. It is included in Profits, Interest, and Investment. I finally got to it Wednesday. I read yesterday that it was the 20th anniversary of Hayek's death. Over at Coordination Problem, Steve Horwitz suggested that everyone provide their favorite quotes from Hayek as a remembrance.

I recently reread Hayek's Denationalization of Money, and there were plenty of good quotes consistent with what I see central to the market monetarist approach--adjust the nominal quantity of money according to changes in the demand to hold money. Still, rather than hunt those up, I am instead going to pick some quotes that I dislike from the 1933 essay.

"The success of almost any investment made for a considerable period of time will depend on the future development of the capital market and of the rate of interest. If at any moment people begin to add to the productive equipment this will as a rule represent only a part of a new process whichwill be completed only by further investments spread over a period of time; and the first investments will only prove to have been successful if only the supply of capital makes the expected further developments at later dates possible. In general, it is probably true that most investments are made in the expectation that the supply of capital will for some time continue at the present level. Or, in other words, entrepreneurs regard the present supply of capital and the present rate of interest as a symptom that approximately the same situation will continue to exist for some time. And it is only some such assumption that will justify the use of any additional capital to begin new round-about methods of production which, if they are to be completed, will require continued investment over a further period of time. (These further investments which are necessary if the present investments are going to be successful may be either investment by the same entrepreneurs who made the first investment, or--much more frequently--investments in the products produced by the first group by a second group of entrepreneurs"

Here we have the early Hayek suggesting that entrepreneurs myopically project the current interest rate into the future. The interest rate is identified with the "supply of capital," which is also supposed to remain constant into the future. In my view, assuming that any current interest rate will remain unchanged in the future would be an entrepreneurial error--an egregious and foolish one.

Hayek ties this "supply of capital" to saving, and he claims the entrepreneurs can act on the basis that the saving rate is more or less constant.

"Very large and unforeseen fluctuations of saving would therefore be sufficient to cause extensive losses on investment made during the period preceding then and therefore to create the characteristic situation of an economic crisis. The cause of such a crisis would be that entrepreneurs had mistakenly regarded a temporary increase in the supply of capital as permanent and acted in this expectation. The only reason why we cannot regard this as a sufficient explanation of economic crises as we know them is that experience provides no ground for assuming that such violent fluctuation in the rate of saving will occur otherwise than in consequence of crises. If it were not for the crises, which therefore we shall have to explain in a different way, the assumption of the entrepreneurs that the supply of saving will continue at about the present level for some time would probably prove to be justified."

Since Hayek wrote these words, there has been a good bit of analysis that suggests that the saving rate is not so stable. Friedman's permanent income hypothesis explains that saving adjusts to smooth consumption in the face of changes in income. When we add "real business cycle theory," or just an even more traditional understanding of creative destruction, a constant growth path for real income and output looks to be unrealistic. More generally, I can conceive of many possible future events, worry about which would result in increased saving. In other words, assuming that the current level of saving will persist and generate a continuing "supply of capital" and unchanged interest rates would be an entrepreneurial error.

At the end of this paragraph, Hayek makes it clear that this supposedly stable path of saving has to do with the allocation of consumption over time:

"The decisions of the entrepreneurs as to the dates and quantities of consumers' goods for which they provide by their present investments would coincide with the intention of the consumers as to the parts of their incomes which they want to consume at the various dates."

What is so striking is Hayek's apparent view that the current interest rate is sufficient to signal entrepreneurs as to how many consumer goods will be demanded at each particular future date. Read again the complicated story of an entrepreneur making investments--producing capital goods or having them produced--that will be used by other entrepreneurs, which will be used by still other entrepreneurs, all of which must have a "supply of capital" available to complete their plans. The first entrepreneur does this with some notion as to what will be the demand for the consumer goods produced by that other entrepreneur some years into the future?

In a world of creative destruction, where new products and new production techniques are constantly being introduced, such planning is unrealistic. A sufficient supply of capital, (which really means, sufficient saving, which really means, productive capacity beyond current consumption,) may be necessary for these plans to be completed. But there are so many other conditions that must be met as well. These other entrepreneurs don't come up with a different production process that uses other capital goods. Some other entrepreneur does not come up with a new way of satisfying consumer wants.

Further, from the perspective of any one entrepreneur, what is relevant isn't the future "supply of capital," in aggregate, but what will be available to those entrepreneurs that will be purchasing his products. This suggest that the "demand for capital," and the opportunity cost of the funds is important. In particular, if entrepreneurs discover some new opportunity that will produce large amounts of some product, this will raise interest rates. Any entrepreneur set up to supply capital goods or other inputs used for "old," less productive processes, would find that his customers, the entrepreneurs involved in those processes, would not have a "supply of capital." The funds will have been bid away by those entrepreneurs involved in the newly-discovered, more profitable projects. One obvious signal of this would be a higher interest rate, even though the total "supply" of capital has not changed, with the rate of saving and the demand for consumer goods in aggregate over various dates unchanged.

Writing all that was a bit awkward. What I would say is that the supply of saving and demand for investment determined one interest rate now. And then, later, due to the discovery of new, more productive investment projects, the demand for investment would rise, as would the interest rate.

In other words, the investment demand "curve" shifts to the right. The higher interest rate reduces the quantity of investment demanded. This is a crowding out of particular investment projects that have lower returns. Those entrepreneurs with specific capital goods that were committed to those projects will suffer losses.

My point is that any one entrepreneur cannot simply identify the current interest rate with the current and future supply of saving. Interest rates can change due to investment demand, and any one entrepreneur must make a judgement about how those changes will impact the demand for his particular product.

Further, if the supply of saving is less than perfectly interest inelastic, then the rate of saving, the current demand for consumer goods and the amount demanded at various future dates, will change due to the discovery of new, more-productive projects.

Hayek continues on to discuss how monetary changes can impact what he calls the "current supply of money-capital."

"If the supply of money-capital is increased, by monetary changes, beyond this amount, the result will be that the rate of interest will be lowered below the equilibrium rate and entrepreneurs will be induced to devote a larger part of the existing resources to production for the more distant future than corresponds to the way in which consumers divide their income between saving and current consumption."

If we imagined that the "supply of money-capital" is given to entrepreneurs as a gift and that they just happen to fund their favorite project with it, then the result might be a bit different than when these funds are lent, so that entrepreneurs must choose to borrow and plan on repaying the funds. This makes the "lower interest rate" important to the supposed distortion. To me, the assumption is that an excess supply of money results in a lower market interest rate--below the interest rate where saving equals investment. In Hayek's words, this would be below the rate where the "the supply of money-capital was of exactly the same amount as current savings." But for this to cause a problem, the entrepreneurs borrowing these funds must be taking the current interest rates, suddenly lowered, as a signal of some new rate of saving, something that supposedly doesn't change much. They borrow money short term to fund projects that will require that they, or perhaps someone else, be able to borrow money at low interest rates in the future. Regardless, they assume that the new, low interest rates will persist.

However, in reality, the new, low interest rate could be a symptom of increased saving, that while "real," is only temporary. And further, it is quite possible that in the future, interest rates will be higher even if the increase in saving was permanent, because new investment projects will be discovered that will result in a higher interest rate.

Taking a lower interest rate today to mean that interest rates in the future will also remain low, is a foolish entrepreneurial error. It is not simply an error because this lower interest rate might be due to an excess supply of money. It is an error even if there were never any excess supply of money. Any analysis that assumes constant investment demand and supply, and so an unchanging natural (or equilibrium, in Hayek's words,) interest rate is mistaken.

Why does Hayek go so wrong? The Austrian version of long run equilibrium was the ERE (Evenly Rotating Economy.) If we think about how a shift in the market interest rate below the natural interest rate would effect the pattern of demand in such an economy, then growing shortages of consumer goods might well develop. (Most economists, including me, would expect these shortages of consumer goods to show up too quickly for there to be much in the way of malinvestment.)

General equilibrium theory (and not the abbreviated macro versions,) describes actual markets where the demands for particular goods at particular future dates meet supplies. That is absurd enough, but they go further where there are markets for all possible future states of the world. About the only value of all of that is to help us keep in mind that it is a bit much to expect "the" interest rate to keep that coordinated. Shumpeter's creative destruction, and Lachmann and Shackel's kaleidoscopic future is a much more plausible way to frame the real world. The notion that there can be a level of short term interest rates such that each entrepreneur can look at it and then make judgments as to the amount of consumer goods that will be demanded at each future date is a chimera.

It is these sorts of considerations that have led me to see the key role for a monetary regime is to adjust the nominal quantity of money to the demand to hold it, and so avoid any shifts in nominal expenditure on output due to shortages or surpluses of money. In my view, the least bad environment for entrepreneurs to face the kaleidoscopic future that is a consequence of creative destruction is one where current nominal expenditure, and more importantly, expected future nominal expenditure, remains on a slow, steady growth path. At least roughly, such expectations both require and are consistent with a quantity of money that adjusts to the demand to hold it, and market interest rates that keep saving and investment equal over the near term. However, it provides no guarantee that current short term market interest rates will persist into the future, much less that an investment made based on that short term interest rate will find consumers ready to buy at the particular future dates when the project matures.

Taking current current short term rates to be the proper gauge of future interest rates is foolish. It is about as foolish as projecting the past trend in the price of an asset into the future. (Housing prices have always gone up, so they will continue to go up. Housing prices have been rising very rapidly for the last few years, so I should buy a house now and make a lot of money too.) To the degree people make these sorts of foolish decisions, perhaps economists should provide some warning. But I don't think having a monetary regime that promises to keep interest rates at a level where such mistakes are avoided is feasible, or even desirable.

Tuesday, March 20, 2012

Ponnuru has an column in the local Charleston paper, the Post and Courier. Mostly it is about whether the recovery act created jobs. It was very similar to this. Still, the ending was great:

"In retrospect, Obama would have been better off pushing for more Fed action in 2009--for instance, the Fed could have stopped paying interest on reserves, announced a goal of restoring nominal income to trend, or both--and skipping the unpopular stimulus. The economy would probably be in the same shape, and we would certainly have less federal debt."

Sunday, March 18, 2012

Ben Shalom Bernanke was raised a druggist’s son in Dillon, South Carolina, a city (today) of 6,800. He studied the Depression as a graduate student at MIT, and as a young academic earned his reputation by expanding on Milton Friedman’s classic monetary history. According to Friedman, the Fed’s failure in the 1930s was a matter of not printing enough money. Bernanke deduced that the real failure was letting the banking system implode. “What Bernanke discovered was that it wasn’t the quantity of money, it was that the banks stopped lending,” says Stanley Fischer, formerly Bernanke’s thesis adviser at MIT and currently the governor of the Bank of Israel. “More than the decline in money, it was the collapse of credit.” The implication was that regulating banks in good times—and, if need be, rescuing them in bad—was of prime importance, something Bernanke would remember in the 2007–09 crisis.

When will economists recognize that Friedman was right and Bernanke was wrong? Or rather, the problem is the growth path of Nominal GDP, and bailing out the banks while letting nominal GDP fall to a lower growth path doesn't fix the problem.

Friday, March 9, 2012

Here is nominal GDP and trend from 1995 to 2006. Excessive nominal GDP growth started in 1996. The peak distance from trend was in 2000. Nominal GDP only returned to trend in 2006. The supposedly excessive growth in nominal GDP is pretty clear from the diagram. It was in 2003.

Here is GDP from 1984 until 2011, with the trend from 84 to 2008. The growth rate of that trend is 5.4%. As can be seen, the close up above shows both the upward deviation in the late nineties (the boom) and the recession that followed. Of course, the current disaster is clear as well.